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S Corporation Update

The business entity continues to grow in popularity but requires attention to its P's and Q's.

S corporations have
become the dominant business entity
type, in part because
requirements for electing the status
have been relaxed and clarified.

An S corporation may now have
more shareholders because
certain family members may be counted as
a single shareholder.

When an LLC files form 2553 to
elect S status, the form
serves as an election to be taxed as a
corporation as well.

The IRS has approved a tax-free
conversion of an S
corporation into an LLC without loss of
S status.

Procedures now are clearer
for an S corporation making
charitable contributions of appreciated
property.

Regular corporations electing S
status still must wrestle
with the potential built-in gains (BIG)
tax, and larger S corporations must file
the new schedule M-3.

Howard Godfrey, CPA, Ph.D., is a professor of
accounting at the University of North
Carolina, Charlotte. His e-mail
address is hgodfrey@email.uncc.edu.

By some accounts, the advent of S
corporations in the late 1950s was the most
notable revolution in American tax policy since
the Revolution. And it’s easy to see why:
S corporation owners can protect themselves
against personal liability and have their income
and gains taxed only once, as opposed to the
double exposure of C corporations and their owners
at the corporate level and again on individual
returns. In 1997, S corporations became the most
common type of entity filing a corporate return
with the IRS. Since then, their numbers have
continued to grow, reaching about 3.6 million and
making the S corporation the most popular
corporate entity in America. “The cornerstone of
America’s small business community,” the S
Corporation Association of America calls it.

Although the structure resting on that
cornerstone has been relatively stable, CPAs must
reckon with several legal and regulatory
developments in recent years that affect such
areas as electing and maintaining S corporation
status, limits on flow-through of losses, basis
issues, payroll taxes, built-in gains, annual
returns and international issues. CPAs advising
businesses must keep informed about these changes,
which affect many aspects of governance and
operation. Here’s an overview of how the S
corporation landscape has evolved, with some new
landmarks and a few extra bends in the road to
business success.

REQUIREMENTS FOR ELECTING AND MAINTAINING
STATUS Shareholder limit. In
2004, Congress increased the maximum number of
shareholders in an S corporation to 100 and
modified the law to allow certain family members
with a common ancestor to be treated as a single
shareholder. As the IRS advised in notice 2005-91,
any family member can make the election by
notifying the corporation and identifying himself
or herself as well as the common ancestor and
designating the tax year in which the election
takes effect. The common ancestor cannot be more
than six generations removed from the youngest
descendant shareholder. The spouses and former
spouses of the common ancestor or any lineal
descendant may also be counted as family members.
Also, estates of deceased family members and
family members who own stock through certain
trusts will not be counted as separate
shareholders.

LLCs and multipurpose form 2553.
A domestic LLC with two or more
owners is classified as a partnership under the
default rules but may choose to be treated as a
corporation by filing form 8832. When corporate
status is chosen, the entity may elect S status.
In the past, an LLC was required to file form 8832
to elect corporate status and then file form 2553
to elect S status. New regulations simplify the
paperwork requirements. An eligible entity that
makes a timely and valid election to be classified
as an S corporation will be deemed to have elected
to be classified as an association taxable as a
corporation. When form 2553 is filed by the 15th
day of the third month of a taxable year, both the
deemed election to be classified as a corporation
and the S election are effective as of the first
day of that year. The election to be treated as a
corporation is effective until the entity files a
different election. These regulations are
effective for elections to be an S corporation
filed on or after July 20, 2004, but can be relied
on for timely elections filed before that date.

In Letter Ruling 200528021, the IRS
considered whether an existing S corporation may
convert to an LLC and elect to be treated as a
corporation without losing its S status. The new
entity would be considered under state law to be
the same as the old entity. The new entity would
conduct the same business as in the past, and
there was no plan to redeem ownership interests.
The IRS ruled the conversion to an LLC followed by
an election to be taxed as a corporation for
federal tax purposes would be a tax-free
reorganization under section 368(a)(1)(F). The S
election would not be terminated as a result of
this reorganization, and the usual basis carryover
rules would apply. In addition, the new entity
would keep the old employer identification number.

IMPACT OF DEBT ON BASIS AND LOSS FLOW-THROUGH

Two cases last year show a wrong and a right
way to increase shareholders’ basis for business
debts so that they may deduct an S corporation
loss.

No pass-through. William
Maloof owned several S corporations that
collectively borrowed $4 million from a bank.
Maloof was jointly and severally liable on the
debt and gave a security interest in a $1 million
insurance policy on his life. The Sixth Circuit
Court of Appeals found that Maloof’s role in the
loan did not cause the corporation to be liable to
him, which would be necessary to create basis for
Maloof in debt of the corporation and permit
pass-through of the losses (see “Tax
Matters,” JofA, Mar.07, p. 73).
Likewise, Maloof’s guarantee of the debt did not
result in an additional capital contribution that
would raise his basis in his stock. Basis would
have increased if the bank had sought recourse on
his guarantee.

Pass-through allowed. In
contrast, Timothy Miller successfully deducted
corporate losses because he personally had
borrowed $750,000 from a bank and loaned the funds
to his corporation. The corporation paid the funds
to the bank in full satisfaction of an existing
corporate debt. The Tax Court concluded that the
series of transactions qualified as an economic
outlay by Miller that left him economically
poorer.

In light of these rulings, CPAs
should advise their clients that a flow-through
deduction is available for a stockholder loan only
if there is clear evidence that the corporation is
liable to the stockholder.

OTHER BASIS ISSUES

Another thorny problem for S corporations
has been how to account for charitable
contributions of appreciated property. The Pension
Protection Act of 2006 brought some clarity. If an
S corporation makes a charitable contribution of a
capital asset having a basis of $100 and a fair
market value of $500, the shareholders will be
treated as having made a $500 charitable
contribution (or each shareholder a pro rata share
of it), unless a lesser amount is required by
special rules of section 170(e). The amount of the
shareholder’s basis reduction in the stock of an S
corporation will be equal to his or her pro rata
share of the adjusted basis of the contributed
property. If the S corporation has only one
shareholder, the basis of its stock will be
reduced by $100, or the amount of the
shareholder’s pre-contribution stock basis if it
is less. This provision applies to contributions
made in taxable years beginning after Dec. 31,
2005, and before Jan. 1, 2008.

PAYROLL TAXES

Regulations proposed in 2005 provide that a
qualified subchapter S subsidiary (QSub) would no
longer be treated as a disregarded entity for
purposes of employment taxes and certain other tax
law requirements. A QSub (or other disregarded
entity) would be liable for employment taxes on
wages paid to employees and for other employment
tax obligations such as paying backup withholding
under section 3406, making timely deposits of
employment taxes, filing returns and providing
wage statements to employees on form W-2. The
owner of a disregarded entity would no longer have
such responsibilities.

But these proposed
regulations won’t be effective until 2008 at the
earliest, because they are applicable to wages
paid on or after the first day of the year
following their publication in final form in the
Federal Register, which hadn’t happened by early
2007. For that reason, Emiel Kandi, the sole owner
of an LLC in Washington state, was unsuccessful in
district court last year in his attempt to extend
the proposed regulations’ provisions retroactively
to payroll taxes owed for 2001. The LLC was a
disregarded entity because a check-the-box
election of corporate treatment had not been made,
the court said.

BUILT-IN GAINS

CPAs should make sure business clients
contemplating an election to switch from a C to an
S corporation are aware of the so-called “built-in
gain” (BIG) tax that could result.

With
the Tax Reform Act of 1986, Congress repealed the
General Utilities Doctrine by reinstating double
taxation of distributed gains by C corporations.
Previously, under the 12-month liquidation
provision, a corporation could sell its assets
without recognizing gain at the corporate level
and distribute the proceeds to its shareholders.
The act also required a C corporation that
distributed appreciated property to shareholders
to be treated as having sold the property to them
at an amount equal to fair market value. Both
types of distributions continued to be subject to
tax at the shareholder level.

Congress
acted to prevent C corporations from avoiding
these new rules by simply electing S status. It
did so, also in 1986, with a new section 1374,
which imposes a tax on the appreciation component
of assets held by a C corporation on the first day
that it makes an election under subchapter S. This
built-in gains tax applies if the S corporation
disposes of the appreciated asset within 10 years
after electing S status. The BIG tax does not
apply to a corporation that has always been an S
corporation. Under section 1374, a corporation
that elected S status while owning appreciated
property must hold the asset for 10 years after
election to avoid the BIG tax upon sale or
distribution to its shareholders.

One
court had held the 10-year holding period started
on the date of the initial election of S status
for a corporation that later lost or revoked its
status and then elected S status again. Final
regulations now provide that the 10-year period
begins on the date of the most recent election.

Example. A corporation
using the cash method elects to become an S
corporation effective Jan. 1, 2007, when it has
accounts receivable of $100,000 for services
rendered before that date. On that date, the
accounts receivable have a fair market value of
$95,000 and an adjusted basis of zero. During
2007, the company collects $100,000 on the
accounts receivable and includes that amount in
gross income. The company recognizes the entire
$100,000 as built-in gain, which is subject to
income tax of $35,000 at the corporate level
(using the highest corporate rate of 35%). The
shareholders will have a flow-through of $65,000
of income (the total income of $100,000 less the
corporate tax paid).

As a general rule,
the amount of built-in gain recognized when an
asset is sold is limited to the excess of its
value over its basis on the date of the S
election. If the company above sold the
receivables, the built-in gain is limited to
$95,000. Other factors may reduce the amount of
recognized built-in gain for a current year, such
as low taxable income for the year, or an NOL
carryover from a year before the S election. A
built-in gain that is realized in the current year
but not recognized carries forward to future
years.

TAX RETURNS—SCHEDULE M-3

CPAs providing tax services to larger S
corporations should take note: Many S corporations
must file a new tax schedule beginning this year.
For tax years ending on or after Dec. 31, 2006, S
corporations that report assets of $10 million or
more on schedule L of form 1120S must file
schedule M-3. Part I of schedule M-3 reconciles
worldwide consolidated net income or loss with net
income or loss reported on the taxpayer’s income
statement or books and records. The adjustments on
part I remove income or loss from nonincludible
foreign and domestic entities. They also remove
certain consolidating adjustments for intercompany
transactions and reconcile income for the
statement period to the corporation’s tax year.
Parts II and III of schedule M-3 reconcile the
company’s net income on part I with total income
or loss shown on page three, schedule K, line 18
of form 1120S. The IRS says M-3 will enable it to
focus more quickly on high-risk issues and
taxpayers requiring attention and reduce time
spent with compliant taxpayers.

INTERNATIONAL TAX ISSUES

In IR-2005-107, the United States announced
an agreement with Mexico to recognize the
flow-through treatment of income earned by
entities that are treated as fiscally transparent.
A U.S. resident who is a shareholder of an S
corporation will be eligible for treaty benefits
on the S corporation income derived from Mexico to
the extent of the resident’s share of that income.

STILL A LEADING CHOICE

Even with these added nuances, S
corporations are likely to remain a favored
entity, especially for smaller businesses. As long
as business owners are poised to take advantage of
pass-through treatment of income, gains and losses
and need a greater level of formality than
partnerships and LLCs, they will choose an S
corporation structure. They’re also likely to find
clearer and simpler tax rules as its governance
continues to be refined. Whatever the reasons
businesses adopt the form, advisers must be
well-furnished with knowledge of the latest
developments.

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